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| German Chancellor Angela Merkel, French President Nicolas Sarkozy |
A range of experts have told Euromoney that the eurozone might be pushed deeper into a recession and the threat of a break-up of the euro is “very real”, after credit ratings agency S&P indicated that the triple-A ratings of Germany, France, Austria, Finland, the Netherlands and Luxembourg were under review.
Yesterday evening, S&P placed all eurozone sovereigns on a credit watch for a downgrade, with five AAA rated sovereigns on a list for a one-notch downgrade. A sixth, France, has been highlighted by S&P for a potential downgrade by two notches.
“If countries are downgraded, it will exacerbate the global confidence crisis,” says Holger Schmieding, chief economist at Berenberg Bank. “It would be one of the factors pushing the eurozone deeper into recession.”
Other experts agree that if S&P were to downgrade the countries, it could cause a blip in a eurozone recovery.
“A ratings downgrade, per se, does not have any immediate impact on growth/recovery, but would have an impact if governments responded with more austerity,” says Marc Ostwald, financial markets strategist at Monument Securities. “[In the markets] the upward pressure on yields/curve steepening sparked by the 10-year Bund debacle will remain a feature, though of course much depends on what and how credible – in markets’ perceptions – is delivered this week. It will however not necessarily have much impact on intra-eurozone spreads, but will almost inevitably lead to spread widening versus the US and Japan, and to a perhaps more modest widening versus the UK.”
Adding to more market concern, other experts suggest that while the potential S&P downgrades are not a complete surprise, it could spell trouble for the euro.
“Firstly, I think S&P are just playing catch-up with the market’s perception of how bad the situation is,” says David Buik, partner at BGC Partners. “The rating agencies tend to be reactive rather than proactive. S&P is not telling us something the markets do not already know. The chips are down and the European Union is in the last-chance saloon. Merkozy must deliver something that is credible and has a chance of being adopted by the weekend. If not, the eurozone is in huge trouble. The threat of the euro breaking up is very real and the fallout will be close to catastrophic.”
Yesterday night, France and Germany arrived at a “comprehensive agreement” on a new set of fiscal rules, in a bid to save the euro. Proposals have included tougher budgetary measures and to relax rules on the private sector taking losses on future eurozone bailouts.
However, not all market participants are confident that this will help the eurozone in the long term.
“Agreeing fiscal disciplines, acknowledging the European Central Bank’s future role, rejecting Eurobond issues and bringing forward the European Financial Stability Facility (EFSF) fund by a year to 2012 is all very laudable, but that does not deal with the debt problem,” says Buik. “Can these profligate countries deliver the austerity programmes – particularly Italy & Spain? Greece cannot! As for France and Germany, the market is not that bothered about the threat of downgrading in isolation. Germany is Europe and France its subaltern.”
Despite Germany and France being on the watchlist, there has been scrutiny as to whether Germany or France will actually lose their triple-A statuses – especially France, which is threatened by a two-notch downgrade.
First, on November 10, S&P said it “mistakenly” announced the downgrade of France and issued a statement two hours after the publication saying it was a “technical error”.
“After the ‘accidental’ S&P message of two weeks ago, a downgrade or at the very least ‘negative outlook’ was being discounted as inevitable, and there are plenty of good reasons,” says Ostwald. “France has been among the worst offenders in paying lip service to the Growth & Stability Pact, bending rules, shovelling off elements of its budget into nebulous off-budget-balance-sheet areas, and displaying as much resistance to much-needed structural reforms as the rest of the ‘Club Med’ group, with its ‘entitlement culture’ (be that working hours, working conditions, labour laws, pensions, social security) and the unwillingness of its political fraternity to challenge the multifarious vested interests of its ruling classes, public-sector workers and unions in effect presenting a brick wall against reform.”
He adds: “More acutely the French banking sector’s external liabilities are in total larger than France’s GDP. Thus the sovereign-financial sector negative feedback loop is in fact far more acute in the current environment than in Italy or even Spain (given that the overall debt to GDP in Spain remains low, though if one adds in Spain’s regions the picture is a lot uglier). I would think there is roughly a three-in-four chance of France being downgraded one notch, and possibly being kept on negative outlook.”
However, Euromoney has reported for some time that France has been on the edge of losing its triple-A status, as its banks hold a large amount of sovereign debt and the country suffers from an ailing economy and government bond market.
In the previous month, Moody’s warned France of an official negative outlook, which could lead to a downgrade in two years.
“The deterioration in debt metrics and potential for further contingent liabilities to emerge are exerting pressure on the stable outlook for the government’s AAA debt rating,” said Moody’s in a report.
Germany has come under closer scrutiny over recent months, especially after Jean-Claude Juncker, Luxembourg’s prime minister and president of the EuroGroup, highlighted Germany’s debt concerns.
“Germany’s debt level is a cause for concern,” said Juncker in an interview with a German newspaper. “Germany has a higher debt than Spain. The only thing is that no one here wants to know about it.”
Furthermore, on November 23 Germany had a “disastrous” bond auction after the Bundesbank revealed that it had sold only €3.644 billion in new 2% 10-year bonds at an average yield of 1.98%.
“The reforms that were forced upon Germany as a result of reunification and adopting the euro at an uncompetitive level, with the benefits of achieving much lower labour costs/higher productivity has imparted a very strong dynamic to the industrial/non-financial sector in Germany, which has been more than amply demonstrated over the past five years,” says Ostwald. “But the truth remains that at 83.2% of GDP, German debt is very high and the failure to address all the failings of the German banking sector, above all the Landesbanken, which were already a mess when it started in 1985, and the enormous external exposures of its banks are a constant reminder that Germany (as with all other G7 countries with the exception of Canada with some caveats about its current budget) is far from being a wonderful credit.”
Ostwald adds: “The downgrade chance is about two in five, with two factors likely to be critical: how much more money will the state have to pump into the banking sector, and what will German long-term liabilities for the rest of the eurozone look like under a revised European Stability Mechanism (ESM).”
However, if the S&P downgrades did happen and austerity measures were taken, market participants say that a deeper eurozone recession could be avoided if the following measures were met.
Schmieding says: “If countries are downgraded the eurozone could be pushed deeper into recession. [Unless] the ECB steps in shortly to stop the eurozone confidence crisis and France finally gets serious about structural reforms, a French downgrade looks almost inevitable. For Germany, a downgrade would be a surprise. But if the Bundesbank refuses to let the ECB save the euro and itself, then a downgrade would be justified. After all, the German economy would collapse jointly with the eurozone, and German public debt would soar in a depression caused by a euro collapse. Such a catastrophic scenario remains highly unlikely, But it is not unthinkable as long as the Bundesbank refuses to soften its stance.”
However the wider issue is to see whether the downgrades will actually be made as many experts have told Euromoney that there is a conflict of interest.
“There is a general market perception that at times there can be conflict of interest because the companies or sovereigns who want to be rated are paying the agencies to grade them,” says Steve Collins, global head of dealing at London & Capital Asset Management.